Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

Make This Your First Rule of Investing

The psychology of incentives will help you find good bets and stay away from corporate disasters.

Psychology and finance overlap in some debatable ways. One way, technical analysis, in which traders attempt to analyze past prices and volume to determine the future, can be likened to palm reading. Another debate centers on the value of gold; "it is worth what others are willing to pay for it," like anything else in a free market, but humans sure chose a metal with little practical utility.

The one psychological factor that isn't up for debate, and should be your first question when researching anything, is: What are the incentives?

If I had a nickel for every time...In general, animals like us seek pleasure and avoid pain. A kid touches a hot stove, and he'll keep 10 feet away from it until he learns how to safely use the appliance. A kid eats a candy bar, endorphins are released, and he'll keep eating candy bars until he feels sick. Replace the hot stove with a disciplinary talk from the boss, jail time for fraud, or losing money, and like the kid, we learn to avoid the behavior that leads to these outcomes. Replace the candy bar with recognition from a respected figure, love, or gaining money, and like the kid, we learn to repeat the behavior that leads to these outcomes.

Incentives guide every decision we make. For example, an employee sees a mess. The employee can spend the time to clean it up, but only if the benefits, maybe of recognition by management, outweigh the cost. Or, a manager sees a mess. The compensation structure doesn't award management to fix messes, instead solely rewarding growth instead of quality. The mess grows until it affects the core business, leading to a broken company.

For real-world examples, look at some positive incentives like insider ownership. If an executive owns plenty of stock, he's incentivized to increase the value of that stock, which matches the shareholders' interest. Elon Musk, CEO of Tesla(NASDAQ:TSLA), owns almost 29% of the upstart electric car company, based on last year's proxy statement. Add in all of the other Tesla executives and directors, and together they own 54% of the company.

Of course, when companies grow to multibillion-dollar sizes, it's difficult for the CEO to own as large of a chunk as Musk. In a case such as Caterpillar(NYSE:CAT), a $63 billion company, the directors own fractions of percents of the company. However, if you look at how much of a director's worth is tied up in company stock versus their current compensation, you can judge how much they feel invested in the company. According to last year's proxy statement, Caterpillar CEO Doug Oberhelman owned about 120,000 shares with rights to 810,000 shares, now totaling over $90 million. His compensation over the past three years averaged about $10 million annually, showing that he has a tidy bit of his wealth tied up in Caterpillar stock.

External incentivesOf course, incentives aren't only internal. You should be very aware of the incentives based around investment advice. Brokers who charge for each transaction will want to increase the number of transactions they handle. Financial advisors who charge a percentage of your assets will want to grow the asset amount to earn more for themselves. In December, the Fool took an in-depth look at one investment firm, Edward Jones, and its incentive structure. The takeaway: "[I]nvestors are at greater risk of being taken advantage of when their advisor is not required to put them first, has strong economic incentives to generate fees, and doesn't need to disclose those conflicts of interest in a particularly clear way."

You should also be aware of the incentives surrounding financial journalism. Short-sellers can make profits by opening short positions and then releasing negative reports, and they often don't have to answer to investors if they're wrong. For instance, Carson Block and his research firm Muddy Waters issued a negative report on Focus Media (UNKNOWN:FMCN.DL) that took the stock from about $25 per share to $17 in November 2011, but the stock has since returned to $25 after a $3.7 billion buyout offer to take it private.

Financial pundits can also talk up stock picks with little track record of their mistakes. While they will surely trumpet successful calls, they can gloss over mistakes because there is no incentive for them to do otherwise. Fool co-founder David Gardner talks more about this in his call for more accountability. For every Motley Fool article, the author's and the Fool's relevant holdings are disclosed at the bottom of the article, and authors are encouraged to track their own record in the Fool's CAPS platform. Investors should be comforted when authors and management openly discuss performance, whether good or bad.

Make it a ubiquitous questionConsider the motivations behind actions, and it can help you predict future behavior. People are averse to pain, whether physical, emotional, or financial. People are also drawn to pleasure, especially financial. Check out a company's proxy statement to learn the incentives that are laid out for management. Consider what motivations are behind an author's take on a stock. Take a look at what motivates a customer to buy a certain company's product. You'll be a wiser investor for it.